Understanding Synthetic Dispositions – Total Return Swap

We continue our Synthetic Dispositions series this week with a look at a total return swap.

As the name implies, this refers to an agreement between two parties to exchange the total return from a financial asset such as a bond or to transfer the credit risk from one of them to the other. Often used by banks to manage their credit risk exposure, the total return from the underlying asset is paid over to the counterparty in return for a fixed or floating cash flow. Credit risk and interest-rate risk is thereby transferred. Because the cash flow is to be received without the recipient actually purchasing the bond, this is a synthetic disposition.  

Example: Synthetic Disposition –
Total Return Swap

Issue:  Vendor A owns a $100,000 corporate bond that pays 3% interest annually. His cost for the bond is $95,000. The current value of the bond is $98,000. He makes an arrangement with Buyer B  to pay all of the bond interest he receives, plus $5,000 on the maturity in exchange for monthly payments of $400 until the bond matures. How is this arrangement taxed?

Answer: If the arrangement was made before budget day (March 21, 2013), Vendor A  would report the income of $400 per month from Buyer B plus the $3,000 received annually from the bond and deduct that same amount as a cost of earning the income. In 2015 when the bond matures, he would report a capital gain of $5,000, the income received from Buyer B, the interest earned on the bond and deduct the interest and $5,000 payment made. 

If the arrangement was made after budget day, Vendor A will be deemed to have disposed of the bond in 2013 for $98,000 and reacquired it for the same amount. In addition to the income and deductions normally reported in 2013, he would report a capital gain of $98,000 - $95,000 = $3,000. In 2015, his capital gain will be $100,000 - $98,000. He will also report the income from Buyer B plus the income earned on the bond and deduct the amounts paid.

Excerpted from EverGreen Explanatory Notes. ©Knowledge Bureau. All rights reserved.

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